The Primary Risk: Estate Tax

Estate tax is imposed on the value of U.S. assets owned by nonresidents when they die. The tax rate is 40%, and for all practical purposes the real estate asset is fully taxable. The exemption amount is trivial: $60,000.

How To Deal With Estate Tax Risk

There are four ways to deal with estate tax:

Don’t Die

Accept the risk, and not die. You laugh, but most people do this.

Die, But Have Life Insurance

Accept the risk, and buy life insurance to pay the tax. (Clue: you have hedged a mortality risk with a financial instrument designed for that specific risk).

Use a Corporate Structure

Eliminate the estate tax risk with corporations.

Own the real estate through a corporate structure. The structure is:

nonresident human owns all of the stock of a foreign corporation,

the foreign corporation owns the U.S. real estate.

Sometimes, for good administrative reasons, the foreign corporation owns a domestic corporation or (less useful) a single-member limited liability company).

The reason this works: the decedent’s gross estate (all the stuff that gets taxed when someone dies) includes stock of a foreign corporation, which is a foreign situs asset.

You don’t look at what the corporation owns — U.S. real estate — to decide the tax consequences of death. So the deceased nonresident’s gross estate does not include U.S. real estate. No estate tax.

Use a Trust

Eliminate the estate tax risk with trusts.

The nonresident individual establishes an irrevocable trust and puts money into it.

The foreign individual does not have any retained interests in the trust assets. “Retained interests” are specific powers that the person creating the trust keeps for himself or herself. Think of this as if the individual made a gift with strings attached: he kept control over the assets or kept some type of economic benefit from the assets that he gave to the trust.

Because there are no “retained interests” held by the individual who creates the trust, there is no U.S. asset to be subjected to estate tax when that individual dies.

The beneficiaries of the trust do not have general powers of appointment over the trust assets. A beneficiary has a general power of appointment when he has the power to force the trust to give assets to him, or pay his debts.

Because the beneficiaries do not have general powers of appointment, there is no estate tax imposed on the death of any beneficiary.

Some Sweeping Generalities

As a general principle:

Overhead: Corporations Better

Corporations are cheaper than trusts–for setup and operation.

Control: Corporations Better

The real estate investor can be the shareholder, sole officer, and sole director in a corporate holding structure. Total control.

With a trust, the investor (who creates the trust) cannot have control over the assets or the economic benefits created by the trust assets. If he does, this creates a retained interest, and he has an estate tax risk.

Corporations are better for control.

Capital Gain: Corporations Worse

Corporations have higher tax on capital gain than trusts. Ignoring State income tax, the Federal tax on capital gain for corporations will be 34% and the Federal tax on capital gain for trusts will be 20%.1

Corporations are worse for capital gain.

Rental Income: Corporations Worse

Corporate structures, if badly designed, have a branch profits tax risk on rental income. Pay normal corporate income tax on the net profit from rent, then pay an additional 30% tax on the after-tax profit.

Corporate structures, if well-designed, have a 30% tax on dividends. Pay the normal corporate income tax on net profit from rent. Then distribute the after-tax profit as a dividend and pay 30% on the dividend.

Corporate structures, if well-designed, must pay dividends in order to avoid the personal holding company tax.

Ignoring State income tax, a corporate structure faces a tax rate on rental income that might reach 54%.

Trusts use the same income tax brackets that apply to humans: the highest rate is 39.6%.

Trusts are better than corporations for rental income.

Homes: Corporations Worse

Corporate structures have potential imputed rent problems if the property is used for personal purposes.

In other contexts, U.S. tax law is quite eager to treat personal use of a corporate asset as creating taxable income. E.g., if your construction company owns a yacht so you can go sailing on Saturday . . . that’s not a business expense.

The same thing is true for real estate. If your construction company owns a condominium in Vail and you go use it during the winter, you have a tax problem.

Trusts do not have this problem. Trusts are the tool designed specifically for the purpose of allowing a person to use an asset for free.

Trusts are better for personal residences.

Portfolio Lending: Corporations Worse

If the investor plans to purchase the property using portfolio interest lending structures a trust will probably be the only structure to use. Here, you lend to yourself and create a tax deduction to reduce your U.S. tax liability.

Corporations almost always fail for this purpose. Trusts are better.

Decision For You

So your decision comes down to . . .

Am I willing to pay higher capital gains tax on sale (and either branch profits tax or dividend withholding tax on rent) because I want to have lower legal fees?

Am I willing to pay higher capital gains tax because I want to retain control over and reap the economic rewards of the investment?

My Analytical Process

The way I generate the information that makes it possible for the investor to choose the holding structure is this:

What You Are Buying: Tax Savings

Compute the marginal capital gains tax savings benefit of a trust over a corporation. Make appropriate assumptions for the holding period and asset appreciation rates.

Compute the tax benefit of using a portfolio interest lending structure for the purchase.

Except for large properties, ignore the tax differential on rental income. The tax cost differential is likely to be trivial.

The Price You Pay: Legal Fees, Loss of Control

Compute the setup and operating cost for a trust structure and for a corporate structure over the expected holding period for the real estate investment.

Assign a dollar value of zero on the loss of control. This is a visceral issue that is either a deal killer or not important.

Money Factors Favor a Trust? Ask the Deal Killer Question

If the numbers favor using a trust (i.e., the tax savings are big enough to matter, after deducting operating costs), see if the client is willing to tolerate the loss of control that is implicit in such a structure.

Apply Truth Serum: Insurance Premiums

Finally, get the premium cost for a 10-year fixed premium term life insurance of an amount sufficient to pay any reasonably expected estate tax.

If the holding period for the real estate is 10 years or less, this insurance policy will provide tax-free cash that can be used to pay the estate tax.

Make a Choice

Make a choice:

Insurance Cheaper. If insurance premiums over the expected holding period will be cheaper than Clever Lawyer Tricks(TM) then buy the real estate in a simple structure designed to avoid U.S. probate, but that exposes the real estate to estate tax. E.g., use a simple revocable trust that owns a disregarded entity that owns the real estate.

Conclusion

Even after all of that, nonresident investors buy real estate directly, exposing their heirs to a massive estate tax haircut.

But there you have it. Fairly easy in concept. A couple of factors — if important — will make the decision for you. If control is essential, then corporations are for you. If portfolio interest lending is essential, then trusts are what you choose.

The amazing power of math will give you the answer otherwise. Numbers. Is there anything they can’t do? 🙂

Nonresidents do not pay the 3.8% (Abomination Unto the Lord) NIIT, so in fact nonresident investors have a lower capital gain tax rate than resident investors. ↩